Investors Bet on Risk

With the macroeconomic uncertainty and headline risk still driving the securitization markets as 2012 comes to an end, it is no wonder that investors are looking for assurance before they sail through the uncharted waters of structured investments.

Getting a handle on how to price risk isn't an easy task with the anemic volumes offering little indication of where the market will be headed.

The biggest issues driving this uncertainty today are U.S. fiscal, unemployment and housing issues, the potential for a collective failure of the European system, and China's housing bubble.

"In regard to the asset types, non-agency RMBS, CMBS and private student loans get directly affected by the market's general bearish view of 'ice age' and anemic growth," said Ron D'Vari, CEO at NewOak Capital. "Since the risks are very macro, it is much harder to price them at loan level. That being said, away from securitization, parties are buying nonagency residential and commercial whole loans."

Currently, the new-issue ABS market is very spotty, compounding the challenge of pricing risk in such an uncertain environment.

"Price discovery is a difficult enterprise in the non-agency market, but the bigger issue at the moment is, given the amount of liquidity that is in the system, investors are looking for a way to deploy those extra funds," said Walt Schmidt, mortgage strategist at FTN Financial. "I think that they would stomach the lack of visibility with prices. It would also help that visibility if a new-issue market would develop."

Still, Schmidt believes that the market can still offer some pretty decent price discovery for investment-grade assets; it is the sub-investment-grade paper where this gets a little spotty.

"It will be interesting to see if, as we come into year end and the focus continues to be on improving capital ratios, dealer balance sheets are still a bit heavy in the sector," he said. "That may lead to some unwinding of dealer balance sheets and create a little bit more price discovery because you are seeing more bonds out there that are being offered."

For investors, the limited liquidity is further compounded by the lack of transparency for some of the issues that are trading. One sector where risk assessment has been difficult is the student loan space where the data is not so transparent.

"We are all 'big boys' in the market enough to understand the risk that we are taking, and if we lose money â€¦ well, that is part of the process," said Rubin Bahar, senior structured product analyst at Eagle Asset Management. "Too often there is nothing that guarantees what risk you are taking on in the market today. So you may think that you are taking on risk A, but it really turns out to be risk B. This lack of transparency makes it hard for investors to plan trades and expect a reasonable level of loss."

Part of the issue with analytics in general is the quality of the underlying data. Very often, people get into the trap of just collecting the data and not understanding the information, explains Salil Donde, CEO at Lewtan.

Investors, he said, must aggressively question the default rate and decide if it is a realistic number being projected.

More accurate data can guide investors with their analysis and help them get a true understanding of the actual value of the underlying collateral.

"You need to know the risk of default and its severity in case of a default, and you can't get those unless you have a true understanding of the value of the collateral," Donde said. "What we do is have the domain experts from the field get the data and go through an aggressive process of understanding if the data makes sense."

Even in the legacy RMBS sector, for instance, there is still good value that can be found. This is not because the tools are very refined for pricing the risk, but because the assumptions investors make are fairly negative.

Buyers price what they consider to be rock-bottom cash flows, which offers them the chance to make investments that end up being safe because they have generously discounted any potential negativity, explained Natixis managing director Ralph Daloisio.

"We no longer have fine-tuned instruments for pricing risk because there are just too many variables at play so pricing becomes more blunt," he said. "As a result, investors are looking for wide margins of error in their estimates before they are willing to put money to work."

D'Vari agreed and believes that smart investors are very picky in wanting to select their own underlying assets and in the current market have a more active voice on risk-based pricing and ongoing servicing.

"These factors drive the market toward club deals - boutique originator/ origination channel, customized underwriting and private deals with the originator having a skin in the game," he said.

Buyer's Market?

Even though buyers continue to have some appetite for distressed assets, Daloisio said that it tends to originate from more opportunistic players such as hedge funds, money managers, and interestingly, insurance companies that can now look at the legacy RMBS-type products. This is because the regulator, through the National Association of Insurance Commissioners (NAIC), has created a model that allows them to be active in the segment.

"Yes, there is appetite, but it won't be as broad or deep of a pool of investable cash as we had for the cleaner new-issue markets - where bonds have higher dollar prices - and more of a par bond market with higher credit rating that is more typical of the bread-and-butter fixed-income universe that we traditionally had," Daloisio said.

Luckily the market is not open only to a select group of investors. Despite the economic volatility framing the securitization market, there continues to be a very well-functioning market for new-issue auto ABS, but even in this sector appetite is reserved for only the very clean, shortdated and high-quality paper that has been relatively unaffected by the financial crisis.

"In terms of getting a new-issue market going for mortgages again, we certainly need to clear out the overhang of legacy product," Daloisio said. "Right now it is a buyer's market for legacy RMBS and, as a result, the yields on that are relatively high. That suffocates the ability to create a new-issue market because in order to get a new-issue market to work, those yields would have to come down."

For Bahar, calling the current market a buyer's market really depends on the investors' point of view. For instance, he said that while some ABS markets look pretty wide - even though they are perceived to offer value - a lack of information and/ or structural issues in the end make an issue tighter than it appears. "The market is OK, but we are living in uncharted waters, so it's tough to determine if we are in the tighter end and it really depends on everyone's feel of the risk," he said.

The CMBS market is probably the one sector that has seen some visibility. There continues to be a strong bid for investment- grade paper in the space. Schmidt noted that visibility in the secondary investment- grade sector is also pretty good.

"In the last few weeks we haven't seen as much bid list activity as we did in the first and second quarters, but we are still seeing a fair number of bonds coming out of accounts where a lot of potential sellers feel that we are maybe near a short-term top in the market for a while, and there are investors on the other side that really need to put assets to work. Many of these investors have a lot of liquidity, and they are not going to meet their benchmark sitting on their cash or on some low-risk asset."

D'Vari noted that the loans that go into the securitization of CMBS are tightly priced. "We see in the CRE space that the players are buying senior, mezz/preferred and equity whole loans," he said.

According to Bahar, even with the uncertainty over increasing CMBS delinquencies, the market works for investors because the data is there.

"Whatever you ask about the collateral, the data is there," Bahar said. "You have a building you can see and touch and that is your collateral. People feel comfortable with these investments because they know what they are investing in versus an asset where there isn't very much data available. If I am buying something and I know the risk I am getting into - that is key."

He added that there is nothing misleading about the representation; you know exactly what the asset is. The best thing to do would be to have in all markets the same disclosures and transparency that the CMBS market has. "That would be ideal. But I know, for example, in autos they can't do it that way because it's a different market," Bahar said.

Esoterics Still on Top of the Game

The esoteric space is another sector that continues to deliver good primary deal flow. At DLA Piper, finance partners Ron Borod and Jonathan Black said they continue to work on programs with new issuers that are getting into the ABS market.

These issuers are often trying to securitize assets that are not yet ABS commodities. In addition to getting a new issuer in to the market, there is the added unknown of introducing a new asset class at the same time.

"Over the last six to eight months, there has been quite a bit of demand for paper that is well structured and offers more yield than traditional ABS," Borod said."That seems to have a nice confluence with where we are focused. Our deals are carefully structured, but because they are a little bit esoteric they generally price wider than traditional auto loan and credit card securitization paper."

According to Black, investors are now more willing to do their own level of diligence than they were pre- 2008, when they relied much more on ratings and the monolines wrapping the senior notes. Now buyers are looking behind the transactions and at the underlying assets and structures as well as the predictability of cash flows.

Despite being esoteric, in many ways these types of deals are simpler and much more transparent than more traditional asset classes, according to Borod. Investors can look to the structure and documents and just understand the credit that is backing up the deal. This is in contrast to doing due diligence on more traditional consumer asset classes, where investors have to sometimes locate a portfolio of a thousand single-family home loans and to predict the performance of these consumer assets in an economic environment that is very unstable. In many ways esoteric deals backed by corporate credits are simpler and much more transparent.

"You see real diversions in the market between deals that are backed by a strong corporate credit and deals that, while they don't necessarily have a corporate guarantee, do have strong mitigation features built into the structure, but it's more of a story," Black said. "The price of that story is more risk sensitivity as reflected in the pricing of the bonds. There is also a real divide between high-credit-quality transactions and those that are perhaps just above investment grade. Once you get above a certain credit quality, the pricing is very good for those securities, but there is a steep fall-off between investment-grade securities and just above investment-grade and non-investment-grade securities."

Borod said that the more expensive price tag has not kept issuers from the esoteric market because they are conditioned to expect higher pricing. "We try to get indicative pricing from the banks that we work with," he said. "The issuers are going into it concluding that those prices work well with their business models and when deals get pulled, its typically because of some unsolvable legal concerns but the pricing hasn't been a deterrent."

Some of the buyers attracted to the market are hedge funds who are having difficulty finding distressed products, which is what they normally invest in. These players have moved money over to the esoteric ABS space because the yields are interesting to them and they are willing to do the work to understand the assets and the structure.

This demand from the hedge fund community, however, ebbs and flows according to general economic conditions, since distressed product availability is a function of what is happening in the economy at a particular time. According to Borod, quite a bit of interest has been generated, particularly on the shorter maturities with relatively high yields.

Brave New World

It is not just investors that are pulling back from securitization, D'Vari said. The investment banks such as UBS and Credit Suisse are finding the securitization machine too risky and lumpy and hence are getting out or scaling back. The more sophisticated and flexible investors find tailored origination infrastructure and are matched with equity/sponsor risk-taker partners. They also seek boutique investment banks.

However, most ABS players agreed that the market's obsolescence cannot happen. The mistake that industry observers make when sizing the current market is that they measure it relative to what it was before the credit crisis.

Donde said that, based on current numbers, securitization volume is still significant. "The absolute size of the securitization spaceâ€¦it's a massive market - securitization is one of the most efficient ways for capital recovery," he said. "You can recover capital through securitization, or through selling whole loan portfolios, or through self-servicing. But with the latter two options, lenders face limitations such as longer time and less efficiency. Securitization is still the most efficient means of capital recovery."

The market will come back, Donde believes, but with quality assets like the current auto deals. Future transactions will have better transparency and will be backed by better-quality assets without mixing in the junk or low-quality assets seen prior to the credit crisis.

"It will come back to being healthy in a smaller form but still a large viable piece of the market, and you will see investors coming back," he said. "We are already seeing autos pick up and seeing people picking up portfolios in Europe - you have seen a change in the mindset. There are clearly buyers and sellers, and over the next year or two you will see it settle back to a norm."

Schmidt believes that appetite for RMBS will come from the current securitization investors. "What happens with asset allocation is that when the stock market slows you tend to get retail money fleeing, but then you get institutional money that wants to go into it," he said. "There is always give and take with equities, but at the end of the day there is this $1.7 trillion sitting on bank balance sheets that the Fed created and that eventually makes its way into the system."

He added that with the current weak economy, most of that will be in the form of fixed income. "Some of the buyers in investment-grade paper have been banks, so they are putting that money to work already - but the growth will come from current investors with large allocations of cash," Schmidt said.

These products have a lot of investors out there, but the space has gotten narrower and institutions like banks are being forced to shun proprietary investment activities so buyers are needed to replace the banks, which just results in creating a dichotomy between what banks have traditionally done and what banks have to do. Donde believes that others will step in where the banks left off and said the market is likely to see a flood of private money coming in. "You will see hedge funds and others with capital sitting on the sidelines, and they will use more sophisticated methodologies in understanding the collateral and the value," he said. "They will go past the rating and these investors will make some good returns."

Where the new investors will come from is an unknown given that the securitization market has hosted all categories of buyers. Daloisio simply said that money will go where it makes sense, and at the end of the day the investment market will adapt whatever is necessary to put that money to work.

"After awhile the pain of the loss dissipates and we end up more or less with the players we had running the old system, just with a different set of perimeters," he said. "What we are experiencing now is a temporary condition, but securitization was born of innovation and it will be reborn of innovation."

Housing Woes and Retail Uptick Rock ABS Pricing

Navigating the non-agency RMBS market is not an easy task given that the market has seen little primary activity in 2011 and lots of volatility on housing stats.

The Standard & Poor's/Case-Shiller 20-city September home price index fell 0.6% on a not-seasonally adjusted basis, the first drop since March.

On a year-over-year basis, the index was down 3.6% in September. The 20-city home price index remains down 31.3% from the July 2006 peak. The national quarterly index also dropped 3.9% in September, an improvement over the 5.8% decline posted in the second quarter.

"We expect October to show another seasonal decline as prices and sales are likely to remain weak during the winter months," S&P analysts said.

By contrast, the Federal Housing Finance Agency reported that U.S. home prices rose 0.7% in both September and the third quarter on a notseasonaly adjusted basis.

According to Jesse Litvak, a managing director at Jefferies & Co., below-investment-grade non-agency paper is trading 10 to 20 basis points off from the highs in March 2011.

In both 2010 and 2011, January and February saw prices move up, and heading into the year end more accounts are trying to buy versus sell, he said.

"In the non-agency space, market players are still running very harsh scenarios on bonds and giving very little credit to any risk on trade," Litvak said. "Yields are still in the 8% to 10% range, and in a world that continues to have tape bombs left and right, I feel like the optionality that exists in non-agency space is pretty compelling."

Litvak believes that more buyers may be looking at below-investmentgrade non-agency paper, which could see pricing steadily move higher into 2012. This is despite the housing sector still facing an uphill battle when compared to other securitization asset classes. The asset class has also been bolstered by the recent Federal Reserve lowering of the interest rate on the dollar swaps.

On the CMBS front, the recent widening trend of past weeks made a reversal given strong post-Thanksgiving sales. According to S&P, sales registered at 6% to 9% above last year. Best Buy, Macy's, and Wal-Mart had strong results based on preliminary data.

Loans on retail properties account for about one-third of outstanding CMBS collateral and nearly half of 2010-2011 vintage transactions. JCPenney, Sears and Macy's are the top 3 CMBS tenant exposures, according to CMBS data provider Trepp. - NC

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